401(k) vs. Roth IRA — Which Is Right for You?


The concept of retirement planning is nothing new. For Gen Y however, there are some unique issues to face when it comes to saving and investing for the years after we stop actively earning an income. With the decline of company pensions and many feeling uncertain about the future of Social Security, young adults know that their retirement plans will look different than those of their parents and grandparents. And thanks to a wide variety of saving and investing options, it’s difficult to determine the right place to invest the money you set aside for retirement. Two of the most popular retirement accounts are the 401(k) and the Roth Individual Retirement Account (Roth IRA). Both are useful retirement accounts that are meant to encourage savings – and each account has its advantages and disadvantages.

Understanding 401(k) Accounts

A 401(k) is an employer sponsored retirement account that allows savers to defer tax to a later date. If your employer offers the plan, it works like this: First, you sign up for your account and choose your investments based on the options available. Then, your employer redirects money from your paycheck before paying federal income tax to your 401(k) plan. The money you contribute to your 401(k) is tax-deferred, meaning it’s not included in your taxable income for the current year. Not only are you able to defer taxes, but employers will often match your contribution up to a certain percentage of your total salary. This percentage usually ranges anywhere from 3% to 6%, and the full match can vary. If you receive a match, this is like getting free money from your employer and at the very least you need to take advantage. Contribute at least enough to secure that match. When you turn 59 ½, you can withdraw the money in your 401(k) without any penalties and you’ll pay income tax on your withdrawal. (Because you didn’t pay the tax when you contributed, you pay tax when you withdraw.) If you try to withdraw the money permanently before retirement age, you pay a 10% penalty in addition to the income tax on the withdrawal. For 2015, if you’re under the age of 50, you’re allowed to put up to $18,000 of pre-tax money into your 401(k) every year.

How Roth IRAs Work

A Roth IRA is an individual retirement account funded with after-tax money that lets you that you withdraw funds at retirement age without any additional taxes. Here’s how Roth IRAs work: You set up the retirement plan with an investment manager of your choice. You take your after-tax money from your bank account and deposit it in the plan on your own. Your employer does not withdraw earnings from your paycheck. When you reach retirement age (and you’ve had the account for five years), you can withdraw the money which includes years of tax-free gains without any income tax. You also can withdraw your own contributions without tax or penalty before retirement age. While you never get to replace the money in the tax-advantaged account, it does allow you the flexibility to pull from a Roth IRA if you’re in a cash crunch. In 2015, you’re allowed to contribute $5,500 to your Roth IRA. However, there are income limits to a Roth IRA – if you make $116,000 as an individual or $183,000 as a married couple, there are restrictions on how much you can put in to a Roth.

Which Retirement Plan Is Best?

Both retirement plans are great places to save for retirement. Each plan has its advantages and disadvantages. A 401(k) is a great plan if:

  • Your employer matches your savings — that’s free money! Contribute up to your employer match in your 401(k) as a first step for retirement savings.
  • You want to lower your taxable income now.
  • You make too much money to contribute to a Roth IRA.
  • You think your retirement income will be less than your current income. If you think this is case, you’ll pay less in taxes by deferring them until retirement.
  • You think you will save more money by deducting your savings from taxable income before the money reaches your paycheck.

A 401(k) does have less flexibility than a Roth IRA. With a 401(k), you are limited to the funds in your employer’s plan. If the plan has high fees, it’s difficult to lower investment cost. You also are not able to withdraw contributions permanently before retirement age without penalty. A Roth IRA is a great choice if:

  • Your employer doesn’t offer a 401(k).
  • You want your savings to grow tax-free.
  • You like that you can access your own contributions before retirement age without tax or penalty.
  • You think your retirement income will be more than your current income. If you think this is the case, you’ll pay less in taxes by paying them now rather than in retirement.

Unlike the 401(k), there are no employer contributions to a Roth IRA and you may not be eligible for saving in a Roth IRA account. Also, if you struggle to save, you might find that you save more with the automatic payroll deductions of a 401(k) (and benefit more from the lowering of your taxable income, which can mean a lower tax obligation and bill). Both retirement plans offer great tax advantages for saving for retirement. Evaluate your personal situation to determine which plan is the best for you. Remember, it’s always possible to save a bit in each to take advantage of both types of accounts.

Mary Beth Storjohann, CFP® is an author, speaker, and financial coach who takes a fun, no-nonsense approach in working with individuals and couples across the country, helping them make smart choices with their money.

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